Everything Must Go!

Now that Jay Powell & Co. have given up the pretense of a soft landing for the U.S. economy, risk markets are busy facing the harsh realities of a global economic slowdown. Insulated by artificially low energy costs and tight labour markets, the exceptionalist U.S. economy rolls on for now, blithely ignorant of the carnage it is creating. The Fed's domestic-oriented, beggar-thy-neighbour policy mandate has painted the hapless monetary policymakers into a corner. They are operating as if U.S. unemployment and inflation exist in a vacuum. The result has been global chaos from a U.S. dollar steamroller that has flattened global economies from an inexorable ascent. Risk assets, of all varieties and all jurisdictions, are for sale.

Powell has only himself to blame, if only he were capable of such introspection. But what do you expect from a trained lawyer turned monetary policy maker? He has been steeped in the art of evidence-based, case-precedent methodology. Ergo, he systematically underestimated inflation simply because it hadn't happened yet. You can't prosecute a murderer before he has pulled the trigger.

This past few years has all the elements necessary for a case study in groupthink. A leader, who rises beyond his level of competence, forced by events beyond his ability to forecast, is making decisions that should have been made much, much earlier. I have depicted this Fed as driving in the rear view mirror. But that doesn't excuse them from blame after tromping on the accelerator and then abruptly jamming on the brakes as they have just done. By doing so, the have exacerbated risks an already risky system. But what do you expect when the members of the FOMC as a group lack either the vision or the courage to make proactivity a part of their policy toolkit.

One can easily blame the prior Fed chiefs for fomenting a culture of transparency and data-dependant thinking. Certainly, Greenspan with his famous 'equity put' cannot be blameless.

The GFC was prolonged by Bernanke's tepid triage efforts. It led directly to Powell's choice of super-dovish QE and its resultant $8Tn balance sheet. But where is the forward thinking? Where is the 'ahead of the curve' proactivity? Where is the leadership?

More importantly, who is left trying to expect the expectations of others? Avid Tuesat11 readers certainly know the answer to that rhetorical question.

Systems often succumb to the second law of thermodynamics - entropy. The economic system is no different. The data that we see reflect only a subset of the available energy. By keeping rates across the curve too low for too long, Powell stored up enormous energy in the monetary system. That is why the sudden onset inflation caught policy makers by surprise. Hence the underestimation of the current inflation.

The randomness of the economy is anathema to the data-dependent thinking so prevalent in today's monetary management thinking. That alone would argue for monetary policy to steer an more middle ground for both tightening and easing. Leaning into the wind in a contrarian fashion is only good portfolio management. Instead, we have witnessed a lurching, reactionary approach form Chair Powell. By using trailing data points to inform the decisions, he will always be trapped skating to where the puck is, not to where Gretzky is, patiently waiting for a pass.

We should have expected all of this, given the fact that a bureaucrat's only motivation is to perpetuate their bureaucracy. The Federal Reserve, for all its positive attributes, is a monster bureaucracy. Those 300 Phds need to do something to justify their existence. Don't just stand there, do something!

Things need to change if we are to improve future monetary policymaking outcomes. Adding an element of proactivity would be a start.

Everything must go indeed. Federal Reserve Chairman Jay Powell, I'm looking at you.

Valuation Reality Check

The stock market is down, but is it out? The blow-off in currency and fixed income markets has not been mirrored in the major equity indexes. Although we have declined back to the June lows, it doesn't feel like a bottom yet. The lack of equity panic makes me nervous. Perhaps the bearishness most investors have been feeling has already been acted upon. Bearish sentiment and positioning - data gleaned from AAII and BofA surveys - are at extremes. But flow data has shown a reluctance on the part of investors to sell. Is it inertia and complacency that reflects the lagged nature of earnings deterioration from the tighter financial conditions?

Bond holders have been hermetically sealed off from proper price disclosure due to the monetary meddling of central bankers for years now. Now the 'ah ha' moment is upon us (only Japan remains as a monetary manipulator) fixed income has been rapidly repriced. Finally there is validation for the term - fixed income. Bondies have been taking one for the team as their equity partners watch from the sidelines. But when the lagged effects of the inverted curve start to show up in their P&Ls, corporations will need to get with the plan and lower their estimates. There is one more chapter in the bear market saga.

Because of this stocks are actually not cheap as they could be, given the huge change in the discount rate. The implied equity risk premium is actually tighter than it was at the all-time highs for the market, especially if one uses a more realistic earnings number than the current rosy consensus. (chart below). But that is not unprecedented for equities, given that they can actually benefit from inflation, especially in nominal terms. I can actually remember when nominal bond yields were actually higher than earnings yields resulting in a negative equity risk premium. The chart only depicts the most recent era.

Equity Risk Premium

Chart; J Atikens TD Securities

The harder question to answer is this: are the attributes of equities as an relatively inflation resistant asset attractive enough for asset allocators to relax their valuation parameters as they did in the 1970s? Time will tell.

Meantime the markets need to deal with the next threat - earnings revisions. Now that bonds are offering value for the first time in perhaps 25 years, this is the make-or-break point for the market. Will a series of earnings resets to the downside be enough of a 'bad news' to be 'good news' to risk assets that have been cowering from the threat of a Federal Reserve that is hell-bent on a hard landing approach?

That is what I have been waiting for to get bullish. As I said two weeks ago, we are very close.

Risk Model: 1/5 - Risk Off

Finally a reading that makes sense.

At only 6% below the 200 dma, but with an RSI well below 40, the market is only short-term oversold. The weekly RSI is well above the levels we saw in June, leading me to stay somewhat cautious. A day traders environment to be sure.

The slowest moving element of the model, the AAII Sentiment Bull/Bear Indicator is at a level of pessimism that is measured in decades, not years. I have taken the weekly data and smoothed it for the following chart. We are seeing levels of pessimism that has exceeded the prior Dot-com / GFC blow-ups.

AAII Bull/Bear 30 Week MA

But before you get all contrarian bullish on me, remember all that valuation and earnings momentum stuff in the previous section. We need some more bad news before the all clear is sounded. This reminds me of the 1981-82 time frame. That experience taught me that things can take longer than you think. The market can stay irrational longer than you can stay solvent was the theme back then.

Bonds are showing signs of rallying today on the faint hope that the Fed will react dovishly to the data from the global economic and commodity markets. That could help bond-like equities most - Growth and Low Vol Defensives mainly. Cyclicals, both Deep and Consumer, will still be challenged by the twin threats of slowing top line sales and rising costs, as this slow motion recession takes a firmer hold on businesses in the coming months.

This looks suspicious to me, given that no such weak data has been forthcoming from the more important U.S. economy which drives the monetary bus being driven by a guy using his mirrors for navigation! The stimulus from the SPR oil bribe being given to U.S. consumers alone has delayed the pain enough for the soft landing crowd to hang on to the dream.

And the surest sign of capitulation would have been a spike in th term structure of the Volatility Index - spot versus 3Mo. I didn't get a bullish feeling from the mini-inversion last week, given the past history shown in the following chart. It can go much higher in my opinion.

VIX/VXV Ratio